I don't think Eric Falkenstein has read my book

Valiant Defender of the Quants Eric Falkenstein has a very weird post about The Myth of the Rational Market. On Seeking Alpha it's even labeled a "book review," which is even weirder because Falkenstein gives no indication of having read the book. The table of contents, maybe—or I guess it's possible that he read the book but did so in such a state of dudgeon because of the blurb from Nassim Nicholas Taleb on the back cover (Falkenstein can't stand Taleb) that he was unable to digest any of the actual text.

My favorite part of the "review":

There are lots of straw men in this book. Efficient markets does not imply price changes ('errors'?) are normally distributed. LTCM's failure, and its positions, were not predicated on the Black-Scholes-Merton option model's assumptions. No one believes markets are perfect.

Okay, let's see: I never say in the book that efficient market theory implies that price changes are normally distributed. I do not attribute LTCM's failure to the Black-Scholes-Merton option model's assumptions. I guess I do push the idea in the book that in the 1960s through 1980s a lot of people at the universities of Chicago and Rochester believed that markets were close to perfect but, well, in the 1960s through 1980s a lot of people at the universities of Chicago and Rochester did believe markets were close to perfect. Straw men, eh?

Anyway, all this is a little disappointing, because I'm a big fan of Falkenstein's Falkenblog and at one point considered sending him my two main chapters on risk measurement (that's chapters 8 and 13, for those of you reading at home) for a sort of stress test. (I didn't simply because I ran out of time.)

But it's not that disappointing. Controversy is good for book sales, and a repost of Falkenstein's screed on Henry Blodget's Clusterstock brought a whole pile of entertaining comments, most of them berating Falkenstein. What I would like best, though, is for Falkenstein to actually read the book— and then go on the debating circuit with me.

Comments

[Eric Falkenstein]

You're right! I did not read your book, and mainly responded to defend Rational, or Efficient, Markets. As someone coming out with my own book soon, I'm sure that's very annoying, and perhaps I'll actually read it and give it a fair look (I note Amazon won't let me read the first 5 pages, so I'll have to go to the book store to sample).

But in my defense, several reviewers you seem to appreciate also don't appear to have read your book, and you had no problem with that.

"that market prices always[sic] incorporate all available knowledge about a security, with the corollaries that stocks will follow a “random walk” and that it is impossible[sic] to beat the market in the long term" ~John Authers

"He also takes us through the academia-driven efficient-market hypothesis (that markets are rational) which, despite being unsupported by facts[sic], has had an enormous impact on markets for almost half a century." ~Robert Hughes

If my take away were that your book demolished the Fraudulent Bell Curve, and I added some really over the top rhetorical flourishes (e.g., 'like Prometheus flying towards the sun, Eugene Fama...'), might you have merely cut and pasted the good parts?

All the best. Really.

[Justin Fox]

Of course I've cut and pasted the good parts. Who wouldn't?

Writers almost always imbue their book reviews with personal agendas, but it's pretty clear that Authers and Hughes had actually read the book. All I was looking for in your post was the line "I haven't read the book yet, but ..."

[Robert H. Heath]

I look forward to reading both Fox's and Falkenstein's books.

I hope one of you explains how "Efficient" came to be synonymous with "Rational". As I understand the term, "efficient" markets reflect all available information in the extremely narrow sense that statisticians use the term. The notion that this is equivalent to prices being correct or "rational" in some Platonic sense of matching the value that a Globally Omniscient Discounter would calculate seems to be an altogether different postulate.

Interestingly, both sides of this debate seem to have encouraged the confusion of the two distinct ideas for philosophical and/or pedagogical reasons. EMH adherents -- having a large overlap with Chicago School free-market believers -- seem to accept the conflation of the two ideas since it's persuasive to claim regulators should exercise a light hand because the market is generally "right". This seems so much stronger than claiming that regulators are no better than anyone else at outguessing the market so modesty should stay their hands.

Opponents of EMH encourage the confusion between the two ideas because it's so much easier, and a lot more fun, to point out examples of crashes, bubbles, market volatility, etc. as common sense evidence that the market cannot always be "right". This does seem a pretty classic straw man approach to the debate.

On the pedagogical front, the subtle switch from "efficient" to "rational" makes a lot of theory more tractable since disequilibrium is hard to pin down mathematically.

Finally, finance professionals such as analysts, M&A advisors and CFO's prefer to speak with confidence (or at least a confidence interval) about things like discount rates and value. Admitting that CAPM-based valuations are predicated upon market valuations and correlations that may be irrational (from time to time) sounds wishy-washy and indecisive.

Best of luck to both of you with your new books.

-rhh

[Julian Svedosh]

I haven't read either of your books, but ... I can't leave some of the claims in these posts unchallenged.

CAPM valuations are NOT theoretically predicated upon market valuations. Future cash flows are an exogenous input, and even beta is theoretically based on the deviation between past anticipated cash flows and risk-free returns. Past prices are used as a proxy for anticipated past cash flows, but if CAPM is useful, they should be a good proxy. This certainly entails some circularity, but CAPM is not a scientific theory (it can't be disproved by empirical evidence), but rather an attempt to codify an analyst's presumptive thinking.

So what's wrong the CAPM? It presumes that the user is prescient about future income. If your crystal ball is cloudy, CAPM will give you bad results. Yet every analyst must make assumptions about the future in deciding on the "right" price for a security. CAPM works very well for fixed-income securities; the innovation was in using the tool for all asset classes. Equity earnings are hard to forecast -- that implies that CAPM is less useful for equities than for fixed income. It's merely a tool. The tool is not bad just because some people use it badly.

Finally, it's time to put to bed the canard about Chicago and EMH . I was at Chicago in the late 60's, and the attitude towards EMH was very ambiguous. Friedman said EMH was like the old saw about democracy: it was a terrible system, but it looked great when you considered the alternatives. The study of market failures has been diligently pursued at Chicago, which is implicit recognition of the weakness of EMH. And for the ultimate confirmation, look at what the stars did: Scholes went to Salomon and LTCM to exploit mis-pricing in the market. Hardly the actions of believer in a strong form of EMH.